Managing in an Uncertain Economy

2010-08-31T10:28:00.000-07:00

Best Practice: Supplier Report Cards

By Dr. Barry Lawrence, Texas A&M University

Senthil Gunasekaran, Texas A&M University

Pradip Krishnadevarajan, Texas A&M University

Wholesaler-distributors run complicated business models. The intricacies of business relationships combined with significant deployed assets makes for expensive operations. Operations expenses are driven by relationships, however. Suppliers have capacity and customers have needs. It is the mismatch between the two that creates the need for distributors and their capabilities. Most of our blogs to date have dealt with managing the customer relationship and methods to minimize its impact on operations. In this blog post, we address supplier impact and the use of the best practice tool — the supplier report card.

The current No. 1 best-selling NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and return-on-investment (ROI). These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we have introduced a best practice and how it can improve earnings and/or ROI under current economic conditions. We encourage you as you participate in this blog to ask questions, debate results, and offer your own experiences with such practices, so that we may further the knowledge of the community and the understanding of the science of distribution.

The book breaks business processes into seven groups (SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING and SUPPORT SERVICES) based on various distributor asset categories. This month, we focus on SOURCE as shown in exhibit 1.

Best Practice: Supplier Report Cards

Supplier report cards are not a new concept, but how firms use them often falls short of best practice. In the supplier relationship, the most important criteria are the profitability the products/services provide, as well as the loyalty, performance, and level of services a distributor needs to offer to sell its product.

Exhibit 2 presents a Supplier Stratification model that demonstrates how to evaluate supplier relationships.

The profitability of products/services is a function of the supplier’s quality and innovation combined with the strength of the brand. Supplier loyalty is usually measured by the level of exclusivity the supplier gives to the distributor. If the supplier will sell to anyone and everyone, the competition will drive out all profitability. Distributor services are the levels of support a distributor must provide for less than cost to drive sales of a supplier’s product. Technical support, warranties, repair, and other services often cost more than the customer is willing to pay. Each of the foregoing can be tied directly to ROI, but the numbers are often soft.

Supplier performance, on the other hand, can be directly tied to expenses and asset efficiency (hard numbers). Some key metrics are lead time, variability of that lead time, incomplete orders, quality issues, and other channel specific ones. Performance metrics can usually be captured easily and placed in a supplier report card to assist in process improvement. The practice levels for supplier performance measurement are as follows:

COMMON practice: (1) No defined performance measurement (2) Based on on-time delivery (reactive measurement only) and quality

GOOD practice: Based on a single factor (1) On-time delivery (2) Lead time (3) Quality and delivery completeness

BEST practice: Based on multiple factors (1) On-time delivery (2) Lead time (3) Quality and delivery completeness (4) Lead-time variability (5) Combination methodology-supplier performance index (SPI)

To be clear, a supplier report card is a collaborative effort where a distributor is seeking to create an awareness of improvement opportunities. There are multiple ways a supplier can respond to a report card. One method is to wad it up and throw it away.

A second method, the theoretically correct one, is to proactively use the information to improve its processes for all customers.

A third method is to leave things as they are and make it up to a distributor. Some suppliers will simply make sure the distributor, who is measuring them, gets better treatment at the expense of other customers. Others will compensate the distributor for the cost of covering their failures. These cases often reflect challenges the supplier cannot overcome.

Case Studies

A distributor of automotive parts was having problems with supplier performance. The distributor had the foresight to reach an agreement with its suppliers on the length of lead times and their variability. Each supplier gave a stated lead time plus or minus a certain amount of time (variability). Later, when the distributor started measuring, it discovered safety stocks were running 38% higher than the supplier’s stated lead times should have required.
The distributor issued the report to each supplier. Some of the suppliers improved their performance, but most indicated that foreign demand (remember this was during the massive expansion of China and India demand for cars) was creating significant backlogs. These suppliers offered instead to directly compensate the distributor through rebates until the problems could be resolved.

Many readers may be thinking their suppliers would never do such a thing, and that this distributor must have had so much power that the suppliers were forced into action. This was actually a midsized distributor dealing with large suppliers, however. The suppliers were more concerned about what their performance failures might do to the distributor’s ability to support the end users.

An example that demonstrates how much impact reporting results can have is one about a small fishing distributor. This distributor had annual sales of $3 million and was dealing with a $3 billion supplier. The distributor discovered through inventory stratification that 80% of the supplier’s products were in the “C” and “D” categories. The distributor couldn’t buy in smaller quantities due to minimum order amounts, and line-card restrictions forced it to carry the slow-move items. The distributor decided to drop the supplier.

To the distributor’s surprise, the local supplier sales rep decided to investigate why the line was dropped. When he found out why, he asked for the data and an explanation of ways the supplier could improve. The distributor explained about the line-card rules and minimums. The sales rep took the information back and, through new minimum requirements and a different incentive program, was able to design a process that worked.

In retrospect, the response is not so surprising. This distributor was well known by peers for cutting-edge best practices. The word would have gotten out at the next fishing show and could have damaged the supplier’s reputation.

Bottom Line

The supplier report card adds value through either reduced inventory or other service costs or direct compensation from suppliers. The investment is minimal (make up a report) and so is the risk. Whatever the supplier does will be beneficial. Ever since quality management made its way into the manufacturing environment, suppliers have been using metrics to improve their operations. The supplier report card will be viewed by most as an opportunity. Those who do not will simply ignore it — a pretty good ROI with low risk.

About this Blog

“Managing in an Uncertain Economy” is a blog created by the Council for Research on Distributor Best Practices (CRDBP). The mission of the CRDBP, created by the NAW Institute for Distribution Excellence and the Supply Chain Systems Laboratory at Texas A&M University, is to create competitive advantage for wholesaler-distributors through development of research, tools, and education. CRDBP encourages readers of this blog to send in comments and e-mail this blog to other interested parties.

2010-08-03T14:56:00.000-07:00

Best Practice: Setting the Min -- Reorder Point (ROP)

By Dr. Barry Lawrence, Texas A&M University

Senthil Gunasekaran, Texas A&M University

Pradip Krishnadevarajan, Texas A&M University

The most difficult purchasing process to understand is setting the Reorder Point (ROP) also known as the “min.” The ROP will constitute the vast majority of the distributor’s inventory and will determine the most important critical success factor, customer service. Each product has an ROP that is often determined by some form of guesswork. Customer expectations have increased over the past 20 years along two axes: availability and selection. Increased availability means a larger ROP. Increased selection means more ROPs. Both mean more inventory. A larger offering leads to many slow-moving products. Slow-moving products often have ROPs that are very high, compared to sales, which leads to inventory increasing at a faster rate when adding new products.

The current No. 1 best-selling NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and ROI. These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we have introduced a best practice and how it can improve earnings and/or ROI under current economic conditions. We encourage you as you participate in this blog to ask questions, debate results, and offer your own experiences with such practices, so that we may further the knowledge of the community and the understanding of the science of distribution.

The book breaks business processes into seven groups (SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING and SUPPORT SERVICES) based on various distributor asset categories. This month, we focus on STOCK as shown in exhibit 1.

Best Practice: Setting the Min (ROP)

The ROP is usually determined by one of two methods: an estimate made by a purchasing specialist or by the information system after receiving input from a purchasing specialist. The first process is static in that it does not change over time unless the purchasing person revisits it. In many distributor environments, this is impractical due to the large number of products. The second process is not static, since the system will change the ROP as the forecast and, perhaps, supplier performance changes. Both methods fall far short of what is possible from both a calculation and relationship management best practice standpoint, however.

We will explore the levels of best practice, the value they provide, and what differing members of the organization must do to achieve the best results.

The practice levels for “Setting the Min” are as follows:

COMMON practice: 1) Fixed percentage of safety stock 2) Multiplier set by planner 3) Standard days of supply 4) Service driven (expediting) 5) Static lead time by planner 6) No forecast error in ROP 7) same service level for all items.

GOOD practice: 1) Statistical replenishment 2) Lead time variability measurement 3) Demand variability measurement (forecast error) 4) Service levels driven by inventory stratification.

BEST practice: 1) Dynamic safety stock 2) Actual demand distributions 3) Multi-echelon inventory optimization 4) Service level determined by inventory stratification and financial constraints (service vs. cost matrix).

The common practices have a great deal of guesswork and tend to be slow to respond to market changes. Take for example the popular standard “days of supply.” The firm determines how many days of inventory it wants to carry and sets up rules that may or may not vary by product type or sales. When supply becomes uncertain due to products going on allocation or disruptions in shipping, customer service failures will occur until someone adjusts the rules. If the days of supply requirement was set high due to poor supplier performance or forecasting difficulty, the days of supply may not get adjusted at all when things improve, thus leaving the firm with too much inventory. All of the common practices lack responsiveness, which leads to customer service failures and/or excess inventory (usually both).

Good practice considers changes in the key inventory drivers, lead-time, and forecast performance, and ties the service level to inventory stratification. The ROP moves with changes in the inventory drivers and reduces or increases inventory thereby preventing stockouts while holding down inventory.

Best practice engages more of the firm’s resources to guarantee a high ROI. In addition to changing the ROP as business conditions change and products gain or lose popularity, best practice uses hub-and-spoke techniques to further reduce inventory. Best practice also treats all inventories as an investment that is measured against other opportunities before deployment. The role of ROP in the replenishment process is shown in exhibit 2.

A home products distributor improved its reorder point and resulting inventory levels in stages. At the beginning of the process, the firm had very large inventories with most products carried in all locations. Gross margin return-on-inventory investment (GMROII) for the entire firm was at 170%. The firm was under extreme pressure by ownership to increase its ROI. The company implemented inventory stratification, statistical reorder points, hub-and-spoke, and a new value proposition for the sales force to deliver.

The first step, inventory stratification, involved using a combination process, as described in the Optimizing Distributor Profitability book, to determine inventory status. The inventory management model is shown in exhibit 3.

“D” items were first removed from inventory resulting in an increase in GMROII to 220%. The next step was to improve forecasting and set dynamic ROPs. The process involved combination forecasting, which we’ve described in our previous blog posts. By tying forecasting improvement to a dynamic ROP (one that changes when forecast and supplier performance change), the firm was able to further improve its GMROII to 235% as safety stocks declined. No attempt was made to improve supplier performance.

The next step was multi-echelon inventory management. The firm first went about consolidating “C” item inventory into Regional Distribution Centers (RDCs). “C” items at branch level would be held at the RDC and removed from the branches. This process involved a great deal of inventory and increased GMROII to greater than 280% after implementation. The reduction was driven by the “square root rule of inventory” where inventories combined from multiple locations will reduce to the square root of the number sites the item is taken from times the average inventory per site.

An example: The firm combined three locations’ “C” inventories into one RDC. Each location had an average “C” inventory of $800,000. The new inventory eventually settled at the RDC at $1,385,000 (square root of 3 times $800K) from the original $2,400,000 (three sites at $800K), a reduction of $1,015,000. Hub-and-spoke essentially reduces the ROP to zero at the branch and moves it back to the RDC. The RDC is able to operate with far less inventory by sales volume since the larger volume leads to better forecasting and supplier performance. Safety stock also gets combined allowing for further reductions.

The final step was to develop a value proposition for the sales force. The changes might cause customers to become concerned that service would decline. The firm designed a value proposition built around reinvesting in “A” inventory. The sales force message was: “We are increasing our fill rates on our most important items (examples listed here) that you use the most. To do so, we will consolidate items you rarely or never use (more examples here). I’ll work with you on those items to make sure you can get them quickly when you need.”

The net effect was a reduction on inventory of $25,000,000 even after increasing “A” item inventory. The increase in “A” items more than compensated for the decreased inventory in “D” items. Fill rates increased as a result leading to an increase in sales. The company had calculated its inventory holding cost at 40%, so the overall impact of the program was a $10,000,000 increase in the bottom line. Earnings increased by nearly 80%.

The most important component was the value proposition delivered by the sales force. The firm had to invest in inventory training for salespeople as well as for operations people. Management had to go through a paradigm shift since they had never considered training the sales force on operations issues before.

The process included many tools (forecasting improvement, inventory stratification, value proposition development, etc.), but the key issue was tying all these things to the ROP. Many firms implement improvements without considering this all-important issue. How will it impact the min? Developing a plan for that process is key to all inventory improvement plans.

2010-07-06T12:37:00.000-07:00

Best Practice: Pricing Optimization

By Pradip Krishnadevarajan, Texas A&M University

Senthil Gunasekaran, Texas A&M University

and Dr. Barry Lawrence, Texas A&M University

Companies have been facing gross margin pressure for many years. The real issue is profitability threatened by customer price pressure (the upper boundary of the gross margin) and a declining ability to reduce cost of goods sold further (the lower boundary of the gross margin). Companies have addressed the problem through attempts to decrease the cost–to-serve, thereby increasing the percentage of profit contained within the gross margin. As the gross margin shrinks, the increased profit percentage can “hold the line” on net profits. Unfortunately, the customer has anticipated increased efficiencies and is requiring higher service levels. The result is a constant battle to protect shrinking net profits. In light of these difficulties, many firms have turned to more scientific pricing methods. Pricing is typically market-based, but pricing decisions are very complex and, when made in an information vacuum, will suboptimize gross margins for the firm. The pricing/discounting decision is an information exercise and determines at least half of the firm’s profitability equation.

Most firms have been experiencing a constant gross margin percentage decline during the last four years. The median gross margin percentage for various publicly traded distributors in the distribution space has dropped from 27.2% to 26.5% from 2006 to early 2010 based on data (aggregated by the authors) from a series of reports published by Modern Distribution Magazine (Baird & Co, 2006-2010).

The current No. 1 best-selling NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and ROI. These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we have introduced a best practice and how it can improve earnings and/or ROI under current economic conditions. We encourage you as you participate in this blog to ask questions, debate results, and offer your own experiences with such practices, so that we may further the knowledge of the community and the understanding of the science of distribution.

The book breaks business processes into seven groups (SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING and SUPPORT SERVICES) based on various distributor asset categories. This month, we focus on SELL as shown in exhibit 1.

Best Practice: Pricing Optimization

Pricing is the gross margin inverse of asset management and procurement procedures. Pricing decisions are very complex. Pricing is typically market-based and, when made in an information vacuum, gross margins can be suboptimized. Since pricing requires basing decisions on a large amount of information, it requires system support. Wholesale distribution pricing has traditionally been approached as an art and not considered a science. Pricing/discounting decisions represent at least half of a distributor’s profitability equation. Pricing decisions on products and services are critical to increasing revenue, profitability, and market share. Applying scientific decision making to pricing is a potential focus area for profitable revenue management.

The practice levels for Pricing Optimization are as follows:

COMMON practice: 1) Cost-plus pricing (2) Cost-plus driven matrix pricing (3) List price or list-less pricing.

GOOD practice: 1) Value-based pricing (2) Pricing matrix based on customer stratification and seller’s item visibility (item stratification).

BEST practice: 1) Pricing optimization models (2) Pricing matrix based on customer stratification, seller’s item visibility, customer’s item visibility, unit cost, and historical gross margins (3) Pricing rules/heuristics.

The most common forms of pricing methods are cost plus, value based, and market-based pricing. In most cases, all three methods are based on a single dimension, which could be cost, value, or competition. The following are characteristics of best practice models:

They are easy to understand and apply when compared to a complex mathematical environment.
The core of the model should be based on variables that are typically readily available and/or easily quantifiable.
They should address data availability and quality issues.
They should leverage and integrate with existing system processes (for example, inventory stratification).
You should be able to implement them quickly with minimal IT resources.
They help achieve incremental business impact (ROI) by using simple pricing models before moving to complex pricing models.

Poor pricing polices and guidelines, a lack of data-driven information, too much speculative information, and the lack of a structured pricing framework will result in margin erosion and pricing inconsistencies. All of these result in the inability to price using item, customer, geography and time combinations. Failure to price effectively results in the following ways:

Paying customers in services to take products
Falling into a price lock once companies set an initial price; it is very difficult to increase later
Losing the opportunity to take advantage of low-visibility and low-sensitivity items that the customer buys infrequently
Leaving money on the table and maximizing revenue at the expense of profitability.

Distributors often try to increase revenue through discounting to attract more customers. This strategy often backfires and ends up generating lower margins. The pricing optimization framework developed by Texas A&M University’s Supply Chain Systems Laboratory is shown in exhibit 2.

Exhibit 2: Pricing Optimization Framework.

This model is designed for implementation in most IT systems. The model is in no way designed to replace a salesperson or pricing analyst. Instead, the process is designed to provide, in a concise manner, relevant information formatted for use without looking through several different screens in the system and conducting significant offline deduction. The system is the science, and the salesperson brings in the art to make an effective pricing decision. The sales force may feel that they are familiar with whether a customer is profitable or not. However, when you have thousands of products and hundreds of customers, no human being can process that much data. A computer can calculate it in a split second.

Pricing in Action

Weather Supply Company (WSC) is a regional heating, ventilation, and air conditioning (HVAC) distributor that sells in three states with 25 stocking locations in the Southwest. Established in the late 1960s, this company is one of the largest independent wholesaler-distributors in the region. The company sells a full line of HVAC equipment, controls, pipes, valves, and industrial supplies for both commercial and residential construction. WSC provides in-depth industry knowledge to help customers develop comprehensive solutions in a fast-moving, rapidly changing business environment. The 25 branches are grouped under five regions.

WSC was growing rapidly, with multiple acquisitions in the past couple of years. Not only had the distributor’s product lines been growing rapidly, but its customer base has been expanding quickly as well. The growth caused the company to expand its service offerings. The distributor had a high cost-to-serve, and it relied on many suppliers. Management wanted to perform a customer stratification process to determine which customers it could grow with and still stay profitable. They wanted to perform the stratification for the following reasons:

Pricing decisions. Different customers require different levels of service. Some customers purchase higher quantities, while others purchase lower quantities. These factors contributed to different costs for different customers. The customer stratification process would help WSC understand where each customer stood with respect to cost-to-serve. This stratification would also help in contract bidding processes.
Negotiations. If a salesperson had information about the characteristics of the customer with respect to other customers, he or she would be better positioned to make the right decisions.

Resource allocation. Sales force and logistics deployment decisions could be made based on customer stratification. For instance, WSC could assign the top salesperson to the most promising customer. The company was performing a great deal of research in lean sales processes. Eliminating nonvalue-added activities from the sales process is the critical success factor to a lean activity. The customer stratification process laid the groundwork for these initiatives.

Areas of opportunity for future growth. There were areas of opportunity to grow in both customer and product market share. A pricing process driven by the customer stratification process would guide WSC in developing strategies for identifying and capturing those opportunities. It could also provide a roadmap for the marketing department to focus its efforts on these prospects.

WSC decided to apply Texas A&M’s pricing optimization framework. WSC’s analysis was done using a Microsoft Access-Excel custom tool developed especially for this project. The tool was used to demonstrate the methodology and identify pricing opportunities. WSC’s management was ready to implement the practice in their ERP system, but the system could not accommodate certain features of pricing rules and final price calculations. They were able to change the configuration for customer and item analyses, but WSC asked its ERP provider for help in implementing pricing rules. As part of the negotiation, they came up with a creative and collaborative approach to implement the best practice and share the resulting costs. The ERP provider programmed the best practice and the distributor served as a knowledge pilot base for programming and development.

WSC brought its 250 key personnel (branch managers, sales managers, sales executives, and customer service associates) for three one-day education sessions to discuss the methodology and its results using WSC’s data. WSC also unveiled a performance plan that explained how the project’s outcome would be linked to employees’ performance. The plan set the stage for stakeholders to apply what they learned in their day-to-day jobs and provided momentum for sustaining best practices in the future. WSC’s pricing implementation was completed in three months, and the ERP provider’s implementation was completed three months later. WSC’s sales reps applied the pricing tool in their pricing decisions. The six-month journey resulted in improvements to shareholder value. Exhibit 3 shows the margin improvements in a few select locations. There was no drop in sales, since the price increases were conservative. The average GM% increased by 4.3% points.

Exhibit 3: Pricing results.

The following conclusions are drawn from the Pricing Optimization research consortium findings and our experience with hundreds of best practice implementations and educational sessions—which provided the opportunity to observe, interact, and learn from thousands of distribution professionals—over the last 10 years:

The potential for pricing improvements exists.
Incorporating both quantitative and qualitative information is a must for successful pricing decisions, but the process should be defined unambiguously.
Involvement of information technology personnel in pricing implementation (from day one) is paramount.
Educating the tactical pricing team (inside and outside salespeople, sales and marketing manager, and branch manager) on pricing methodology and getting their buy-in is the single-most important factor in any successful pricing implementation.
Defining and detailing the roles and responsibilities of various stakeholders involved in the pricing process is a key factor (Who does what and who is accountable for what?).
Finally, defining quantitative metrics and connecting them to incentive or compensation structure is a vital link in sustaining successful best-practice implementations.

2010-06-02T10:38:00.000-07:00

Best Practice: Forecasting

By Dr. F. Barry Lawrence
Texas A&M University

In the previous blog, we addressed growth and sustainability while maintaining return-on-investment (ROI). Many best practices exist and have been well implemented in information systems to deal with assets and expenses. Increasing revenues is the third part of the equation and the required ROI level is based on the level of risk.

Risk is driven by forecasting. If we miss our forecast on revenues, expenses, or asset needs, we risk not hitting the ROI target. To ensure they meet their ROI requirement, firms will set a higher requirement on activities with a high potential forecast error. The most common cause of misestimating expenses and asset needs, however, is a missed revenue forecast.

The forecasting best practice has advanced dramatically since the introduction of enterprise resource planning (ERP) systems. While the process was hampered by data integrity problems, great strides have been made, and historical forecasting has become more stable. Challenges remain, however, especially where data is scarce.

The current No. 1 best-selling NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and ROI. These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we have introduced a best practice and how it can improve earnings and/or ROI under current economic conditions. We encourage you as you participate in this blog to ask questions, debate results, and offer your own experiences with such practices, so that we may further the knowledge of the community and the understanding of the science of distribution.

The book breaks business processes into seven groups (SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING, and SUPPORT SERVICES) based on various distributor asset categories. This month, we focus on STOCK as shown in exhibit 1.

Best Practice: Forecasting

Forecasting best practices are divided into three areas: historical (statistical), combination, and collaborative. Commonly used statistical models have been around for many years, and most improvements have been about the forecasting process and not mathematics. Combination forecasting is a rigorous process that can only be conducted on a few key items. Finally, collaborative forecasting requires customer and/or supplier input and is even more work intensive. Human expertise can add great value to forecasting, but it can add bias as well.

The practice levels for Forecasting are as follows:

COMMON practice: A single historical forecast method applied to all products calculated by the system and frequently overridden by purchasing professionals. No use of forecast error metrics.

GOOD practice: Multiple forecasts are run and measured. The best performing forecasting model is selected based on error metrics. Combination forecasting is used where error rates are unacceptably high.

BEST practice: Combination forecasting is applied and augmented by additional information gathered through supply chain alliances with customers and suppliers (collaborative forecasting). Mathematical modeling may be applied through regression techniques.

Mathematical Modeling

ERP systems have allowed for pretty extensive statistical forecasting where data integrity allows. Forecasting models stretching back over 50 years are common in most ERP systems or can easily be accessed from textbooks and put into spreadsheets. These techniques include moving averages, exponential smoothing, models for seasonality and trend, and methods that compare all and choose the best performing one to use on whatever product is being forecast.

The forecast error metrics can measure the average magnitude of error (high or low), the average overall error, and many other views. The error metric (or combination of metrics) that management feels best minimizes the risk of stockout, expenses, or necessary assets (inventory) can then be used to pick the forecast model to trust.

Most distributors do not optimize this mathematical modeling process. They believe that forecasting will never be accurate due to erratic customer behavior, data integrity problems, long supplier lead times, and/or a lack of skills in their purchasing team. They instead let their IT provider set up the system with minimal input. They do not investigate causes of customer ordering patterns, root out data integrity problems, collaborate with suppliers to smooth out lead times, train their purchasing staff, or even try to understand how to measure forecasting and set requirements.

There is no question that even with the best-designed mathematical process, the resulting forecasts will still be highly inaccurate. This is no excuse, however, to not get this phase right. Once the mathematical forecast is properly designed, it acts as the foundation for all that follows. If not properly set up, it will confound all other efforts. Leaving forecasting to external parties (IT consultants) and not training your team is unacceptable.

If the forecast is not trusted, people will deploy inventory to protect against stockouts. Nobody knows the true cost of a stockout, but everyone agrees it far exceeds the cost of inventory. This problem is the number one cause of excess inventories and customer service failures. The distributor has only so many resources it can apply to serve the customer. Ineffective forecasting guarantees there will be too much inventory in some products and customer service failures in others. The role of forecasting is shown in exhibit 2.

Decreasing the Forecasting Burden

If we build the right mathematical process, the next step will be to apply human evaluation to forecasts with excessive error rates. This process is called combination forecasting and has further reduced forecast errors in applications we’ve seen by as much as 50% over mathematical models alone. Effective combination forecasting is a time-consuming process, however.

The steps are simple in concept but very difficult in practice. First, the mathematical model is run to the greatest efficiency possible. Second, the error metrics determine which forecasts are still performing poorly and submit those to purchasing experts to investigate for data integrity problems and trends that are not captured in the data (for example, sharp recessions like 2008, product shortages that will cause long lead times, etc).

Purchasing teams will not have sufficient time to conduct this type of analysis on the 20,000+ products that many distributors carry. To be feasible, the job must be reduced to only the most critical items that require attention. The first step is to use inventory stratification to reduce the purchasing task for both the human and mathematical modeling. “A” and “B” items with high error rates will have to be reviewed. “D” items should be eliminated from inventory and do not need to be forecasted. “C” items, as a previous blog suggested, should only be reordered at the supplier minimums and have little to no reorder point. The correlation between inventory rank and demand stability index (DSI) is shown in exhibit 3.

This process leaves only “A” and “B” items to be forecasted. Since most distributors, who have properly implemented inventory stratification, find more than 70% of their inventory to be “C” or “D,” this process tremendously reduces the forecasting task. “A” items are well behaved and will typically have low error rates. Properly setting inventory stratification is critical, however, to prevent too many items from being put into the “A” and “B” categories. The forecasting framework is shown in exhibit 4.

Forecasting with Unreliable Data

When there is no history or the data is scarce, forecasting becomes extremely difficult. New product introductions, new customers, new territories, and other growth issues covered in May’s blog are very troubling to forecast. If we do not forecast, however, we have no idea what resources will be needed, and we can’t estimate what assets will be used or what expenses will be incurred. We will also not be able to predict what revenues will be produced. This lack of information will produce a high level of risk driving up our ROI requirement, and thereby killing many initiatives.

Forecasting without historical data is difficult but not impossible. The next level of forecasting, collaborative, is rarely used for established products due to its work- intensive nature and alliance problems. Collaborative forecasting is work intensive, since collecting information from customers and suppliers is time consuming and requires human and system handoffs of data that will produce data-integrity issues.

Some large customers have used collaborative forecasting by giving their suppliers the customers’ forecasts and expecting them to follow them. Many distributors report instances where the forecasts were so inaccurate that the motive seemed to be to inflate the distributor’s inventory rather than to make the supply chain more efficient.

Suppliers often have valuable information to share as well. Since a supplier can see how a new product or customer base performs in other regions, they can provide a distributor with valuable information. Many times, however, a supplier, to encourage a distributor to invest, will inflate these numbers.

Other sources can include government-collected data (for example, housing starts, population growth, production numbers, etc.) or data from previous investments of a similar nature.

Collecting these various data sources is work intensive, and the forecasting results may be questionable due to the many potential sources of error. Therefore, collaborative forecasting is rarely used for standard forecasting processes, but is the only alternative when data is not available. Two common ways to calculate a collaborative forecast are human estimation and statistical regression.

Human estimation is most popular, since it is quick and flexible. Contrary to popular belief, it can also be fairly accurate. The key is accountability. When people engage in forecasting, the information delivered to them must be as accurate as possible, and their results must be measured. Measuring human forecast error will create a process whereby the expert will investigate which data gave them the best results and how to improve other sources of data.

Statistical regression is a mathematical process that conducts a very similar analysis. All numerical data (for example, supplier estimates, customer forecasts, similar investment results, government data, etc.) are fed into a mathematical model that will produce a forecast and simultaneously will determine which information sources contributed to forecast accuracy and which did not. Those that did not contribute can be improved for better results or can be eliminated, reducing the data collection workload.

A Cautionary Tale

A building materials distributor developed a complex combination forecasting method. Data was fed into the system and multiple forecasting models were run on the data. The forecasting model that produced the lowest error rate was applied and the best result was continuously measured. Where forecast error on “A” and “B” items was higher than 30% and 40% respectively, the forecast was flagged for purchasing to review. The process dramatically reduced forecast error and inventory at first.

The settings for what qualified as “A” and “B” inventory were too loose, however, and the task soon became overwhelming for purchasing. Purchasing experts were also not trained on how to evaluate forecasts and data. The team began to trust the system even when they should not have, and many high-profile forecasting errors took place ,causing many questions to be raised. It was easier to blame the IT system than to accept blame for the lack of training and a less-than-rigorous human process.

The decision was to discontinue the process and go back to the informal forecasting process. Inventories increased and profitability dropped. New management came in and hired a new set of consultants to improve forecasting. A new IT solution, nearly identical to the previous one, was introduced, again without proper training, settings, measurements, etc. Since many people remembered the signs of failure and lacked confidence in the new application, it took even less time to fail.

A Better Result

A chemical distributor developed a forecasting process that encompassed the sales force, customers, and suppliers. The distributor sold different products in different regions, since they sold primarily to large customers. Each salesperson, therefore, had a few customers buying a very few products.

The distributor had alliances with suppliers where they accounted for more than 80% of the supplier’s production. If the distributor’s forecast was inaccurate, the supplier had little chance of helping the distributor recover. Since the products were very specific, perishable, and could not be acquired elsewhere, it was imperative that the forecasting was accurate.

The sales force was presented every three months with a historical forecast for the products they sold in their region. The forecast was spreadsheet-based, since no information system could support the process that followed. The salesperson was expected to work with customers and reach an agreement on what would be produced and consumed. The salesperson was evaluated and his income was directly tied to the accuracy of the forecast.

Since the customer was consulted and understood the gravity of missing the forecast, forecast error was very low and manufacturing scheduling effective.

Train, Train, and Then Train Some More

Forecasting is one of the most information-intensive processes. While information systems are where it all begins, human interaction is required for critical products and uncertain environments. Well-designed systems, proper collaboration, and accountability, all play their parts, but nothing as complicated as forecasting can succeed without well-trained sales teams and purchasing teams.

About this Blog

“Managing in an Uncertain Economy” is a blog created by the Council for Research on Distributor Best Practices (CRDBP). The mission of the CRDBP, created by the NAW Institute for Distribution Excellence and the Supply Chain Systems Laboratory at Texas A&M University, is to create competitive advantage for wholesaler-distributors through development of research, tools, and education. CRDBP encourages readers of this blog to send in comments and e-mail this blog to other interested parties.

2010-05-04T09:10:00.000-07:00

Best Practice: Managing ROI-Driven Growth

By Dr. F. Barry Lawrence
Texas A&M University

So far, so good, most markets are on the mend and wholesaler-distributors are seeing improvements across the board. A clear message came out of the recession: Managing working capital is the short-term goal; managing return-on-investment (ROI) is the long-term one. To do so, distributors must grow profitably. The concept is deceptively simple, however.

Many business people are trying to understand what is being called the “new normal.” The concept is that business conditions will not be the same after the “Great Recession.” They believe that a new model is emerging, and that those who understand and respond to it will flourish. Those who do not will perish. Okay, we’ve heard that before, and anyone who has been in business since the 1990s is probably somewhat sick of such forecasts. They are nearly always wrong.

The trouble is the people making the claim are not just consultants trying to sell their services this time. They are smart business people at best practice firms. They are not publishing their opinions to gain notoriety. They are changing their business models, however.

The new normal is not yet clearly defined, but a couple of common themes are coming from top business thinkers. They involve growing profitably and sustainability.

Growing profitably or, more accurately, with a solid ROI, is a function of four financial inputs:
• Sales

• Expenses

• Assets

• Risk.

The first three constitute the ROI equation; the last one determines the right outcome.

Steps

• The first step is to determine your risk tolerance.

• The second is to determine your potential opportunities.

• The third is to select the opportunities that match your profile of an acceptable risk/return ratio and rank order them to determine which fit within your resource capabilities.

• Fourth, determine what best practices will apply to the venture.

• Fifth, use those projections to govern the project through to a successful and sustainable part of your firm’s portfolio.

Sustainability means the process will continue to operate efficiently. It also means the firm will continuously introduce new innovation to the process to maintain its appeal to customers. These dual objectives require a corporate culture that embraces change, encourages innovation, documents and standardizes processes, and whose human resources are trained and motivated for the task.

The current No. 1 best-selling NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and ROI. These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we have introduced a best practice and how it can improve earnings and/or ROI under current economic conditions. We encourage you as you participate in this blog to ask questions, debate results, and offer your own experiences with such practices, so that we may further the knowledge of the community and the understanding of the science of distribution.

The book breaks business processes into seven groups (SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING and SUPPORT SERVICES) based on various distributor asset categories. This month, we focus on SUPPLY CHAIN PLANNING as shown in exhibit 1.

Best Practice: Managing ROI-Driven Growth

ROI-driven growth involves identifying opportunities, determining their value, sizing the necessary investment (human as well as financial resources), assessing the risk, and selecting the right options.

The practice levels for ROI-driven growth are as follows:

COMMON practice: (1) Sales force identifies a new application or customer set, (2) Expert (sales) opinion is applied to determine risk and reward, and (3) Selection is made based on biased opinion and force of personality.

GOOD practice: (1) An opportunity assessment is conducted to forecast sales potential, (2) Expenses to support the new opportunity are calculated for varying levels of the forecast, (3) Necessary investments are calculated, (4) ROI is calculated and compared to corporate hurdle rate, and (5) Those activities clearing the hurdle rate are prioritized on perceived risk/return ratio and compared to available resources.

BEST practice: (1) GOOD practice analysis is enhanced with strategy/structure match where the selection is evaluated on its consistency with long-term corporate goals and with existing processes, (2) Sustainability is created by first establishing a measurement system to govern both the implementation and continued process operations and second documenting the process and training to establish a culture of quality and innovation.

The New Normal?

One of the characteristics of the new normal may be shorter, more frequent recessions. JIT (just in time) has reduced supply chain inventories to the point that booms are harder to sustain and recessions cannot last as long. We are still struggling with forecasting this process, but the current recession holds some lessons.

The 2002 recession came as a major shock to most distributors, but they had been working on their inventory processes for quite awhile. Retailers and manufacturers were already running lean on inventory (mostly using the distributor’s inventory), but distributors were still carrying too much. Since they had new inventory processes in place, they adjusted quickly to the downturn. Electronics distributors saw inventory turns drop from 7 to 1 in a matter of months. They stopped ordering and right-sized their inventories quickly, but the impact to manufacturing was horrendous.

2009 brought challenges on a scale not seen since the Great Depression. Distributors were now more agile and manufacturers wasted no time in shutting down operations to control costs in the supply chain. The result was inventory shortages by the summer of 2009, which caused a turn in the economy sooner than most had predicted. Predictions that the economy would have a double dip or a slow climb out were further confounded by the lean distribution inventories. As it sells, it gets ordered, as it gets ordered, it must be produced. When there are any sign that things will soften, manufacturers shut down and distributors stop buying.

Becoming more agile with inventory is a lot easier than closing and opening manufacturing processes, but we should expect manufacturers to make their processes more agile as well. The result could be a new normal of more frequent, shorter, shallower recessions, and less extreme booms. The wild card in this equation is government actions. Programs to overcome the 2002 recession superheated the economy and caused an unwarranted increase in capacity that no doubt contributed to the current recession. Still, whatever the new normal may be, these new, more agile processes make sense.

An interesting outcome of this new normal is that well-run distributors can capitalize on recessions to grow. One distributor described it this way: “When a downturn hits, we reduce inventory and accounts receivables, which increase our available capital. We then use that capital to acquire competitors or launch into new markets when the cost of doing so is very low. Recessions have now become a good thing for us.”

ROI and Growth

A virtuous ROI cycle is illustrated in exhibit 2. A new market opportunity is capitalized on by an acquisition, new product introduction, green field startup, new service model, etc. Sales increase faster than expenses leading to an increase in net margins. If net margins increase at a higher ROI than the firm’s current business processes provide, investors are encouraged to invest more into the new venture.

Another possible model is to improve processes and drive down expenses or assets. The increased ROI allows the firm to decrease pricing or simply capture higher margins. The increase in ROI again encourages investors to put more money into the firm’s improvement efforts.

Exhibit 2: A virtuous ROI cycle.

A Case Study

A small distributor had implemented inventory and accounts receivables management best practices when the recession hit. The distributor continued to manage its assets well and the decrease in inventory together with decreased accounts receivables caused an influx of cash. The firm was very liquid at a time when its competitors were not.

The firm was interested in expanding its territory or service offering. It was not clear which model would work best, so a detailed analysis was conducted using ROI as the driver. The firm was privately owned with a highly competent management team. A new acquisition would be closely supervised, and the firm was experienced in acquisitions. This experience, together with a highly reliable management chain and thorough understanding of the market (the acquisitions would be within 150 miles of their territory), demonstrated a low risk, so the firm set its minimum hurdle rate for ROI at 18%.

Three acquisitions were identified:
• The first was a distributor with an identical business model.

• The second was in a related and complementary product line.

• The third was a service firm that would complement the firm’s existing processes.

Each firm’s sales were tracked and corrected for the recession, and a conservative forecast was put in place for future growth. The forecast was then linked through the income statement of each to determine what their respective expenses would be.

Best practices were compared between the purchasing firm and each acquisition to determine how the merged operation would operate and how any reductions in costs would be captured. This analysis led to estimated net earnings for each of the next five years. The required investment was calculated by a 3X multiple of each firm’s current earnings, plus 75% of accounts receivables and 50% of inventory and adjustments for debt and other assets. The result was a 4- to 5-year payback on each acquisition or an ROI of 20% to 25%.

The firm then assessed the strategy/structure match. The services distributor was determined to be most outside of the firm’s core competency and its low margins were a concern. Service firms have few assets, so while the ROI looked good, the margin for error was small. The distributor with the related product line was less risky, but had a poor record on accounts receivables. The final distributor from the same product/service offering had the overall best ROI, but a large inventory compared to the acquiring firm. The structure was a good match and the proximity of territory meant that assets could be shared, promising opportunities to reduce inventory and other assets (for example, one warehouse was perceived as redundant).

After making the selection, the next step was sustainability. The best practice states that integrating acquisitions should happen as quickly as possible from a human resources standpoint. Delays in eliminating redundancies and creating career advancement opportunities for valued new employees will result in productivity decreases for some and the potential loss of high performers if anxieties are not relieved quickly. High-performing employees are embedded in the actual value of the firm and their loss decreases the value of the acquisition.

The firm treated each asset and new employee as a valued resource and an implementation plan was made to capture the planned ROI with the involvement of key personnel from the acquisition. Training, career path, and involvement were preplanned especially for high-value employees. Transitioning best practices from one firm to the next were planned with metrics to ensure ROI and create sustainability.

Capturing best practices and ROI in standard operations has gone on for some time and is well represented in the Optimizing Distributor Profitability book (http://www.naw.org/optimizdistprof).

Doing the same for growth implies new best practices and new perspectives. If the new normal is as we propose in this blog post, there is a need to manage growth very tightly to maintain the necessary flexibility and capture the opportunities associated with the new business environment. The upcoming Council for Research on Distributor Best Practices (CRDBP) consortium title, “Optimizing Distributor Growth and Market Share” will treat this need as its core mission. The consortium brings together many best-practice companies thereby combining the wisdom of many as opposed to the thoughts of a few. To learn more and to join this consortium, go to http://www.naw.org/crdbp/growth.php.

2010-04-06T07:11:00.000-07:00

Best Practice: Network Optimization

By Dr. F. Barry Lawrence
Texas A&M University

The struggle continues in spite of the light on the horizon. Some are running out of rope, but most have adjusted. One could argue that wholesale distribution was built to overcapacity during the massive expansion associated with the Just in Time (JIT) movement of the 1980s and 1990s and that we’ve been struggling with adjustments in the 2000s. JIT drove a great deal of new business to wholesaler-distributors as manufacturers and retailers sought to decrease inventories, but it also decreased their net margins through an increase in cost to serve.

The initial impact was the 2002 recession, the first indication that the market would not grow continuously. The upturn from 2003 to 2008 gave distributors some relief but most would agree it was not like the 1990s. If distributor growth was not spectacular at that time, we should not have been surprised by how hard the next recession hit. The financial crisis further demonstrated how vulnerable distributors are when our overloaded services (accounts receivables, inventory) strangled cash flow almost instantly.

Going forward, the distributor’s market will grow steadily, but not nearly as rapidly as in the past. For distributors to experience real growth, they will have to provide excellent and innovative services and products. The combination requires best practices in asset management and supplier management. Past blogs have dealt with customer relationships, inventory, transportation, lean processes, and information technology. This blog will address network optimization, the process of aligning all resources in the distributor’s organization to optimize customer service and profitability simultaneously. Network optimization is a very mature best practice but has, to date, not been used extensively by distributors.

The popular-selling NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and return-on-investment (ROI). These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we have introduced a best practice and how it can improve earnings and/or ROI under current economic conditions. We encourage you as you participate in this blog to ask questions, debate results, and offer your own experiences with such practices, so that we may further the knowledge of the community and the understanding of the science of distribution.

The book breaks business processes into seven groups (SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING, and SUPPORT SERVICES) based on various distributor asset categories. This month, we focus on SUPPLY CHAIN PLANNING as shown in exhibit 1.

Best Practice: Network Optimization

Network optimization involves mathematically modeling the distributor’s operations. The model will include an objective (maximize profitability or minimize cost) and a set of constraints (financial, customer delivery requirements) that may or may not be violated. Management establishes the goals of the firm and the model is based on real conditions. Once the model is created, it can be run repeatedly to determine the optimal configuration of assets in the distributor’s supply chain. Sound difficult? Let’s run through some examples to demonstrate how others have carried out a network optimization.

The practice levels for supply chain network optimization are as follows:

COMMON practice: (1) Experience, (2) Spreadsheet analysis

GOOD practice: (1) Single-asset focused mathematical model (for example, optimizing facility location or transportation)

BEST practice: (1) Multi-asset focused mathematical models (for example, optimizing inventory and transportation together), (2) Stochastic (uncertain) mathematical models

A building materials distributor had acquired one of its largest competitors. The firm’s network went from 50+ to 80+ locations with many redundant facilities. The firm conducted a network optimization with the following parameters:

Objective: Optimize profitability

Constraints: Next-day delivery and transportation fleet capacity.

It sounds deceptively simple, but the objective and the constraints are very complex to model. Once modeled, however, the firm was able to run it over and over with different assumptions: changing demand (forecasting), differing levels of transportation capacity (selling or adding trucks), different levels of financial investment (inventory levels), etc. After many runs, a solution began to emerge. The model recommended reducing the number of facilities from 80 to 49. The researchers, however, recommended only eliminating the top 10, since market conditions would change and an operation that was not quite optimal now could be in a few years.

The firm went about consolidating the top recommendations. The most extensive consolidation took place in northern California. Three branches were to be combined into one. The branches were on property valued on the firm’s books at $200,000 each, but could be sold for $1.2 million each (a $3 million windfall). The consolidated center was able to operate on $1.7 million in inventory as opposed to the $3.2 million, which had been scattered through the three branches. The firm had calculated a 40% holding cost, so the bottom line impact for inventory was $600,000 ($1.5 million times 40%), an increase in net margin for the three branches of nearly 100%. Customer service was not compromised, since the model treated it as a “hard” constraint.
Network optimization is to distributors what aggregate planning is to manufacturers. Aggregate planning is the process of determining how manufacturing resources will be used in the coming year. Conducted each year, it ensures that strategic goals for customer service are met with optimal usage of equipment (maximizing ROI). Distributors’ “manufacturing resources” are warehouses, transportation, inventories, accounts receivables, and all other resources engaged in customer service. Network optimization determines how to optimally deploy them. Unfortunately, this process is carried out only by a few distributors and then only after acquisitions or a long period of organic growth that has resulted in an inefficient network of investments.

Best practice states that distributors should conduct network optimization annually or every two years at least. The result would be more efficient use of resources and higher ROI, both necessities in the current market. Growth, in particular, will require higher levels of service or operations in new territories, which will consume additional resources. For most distributors, future investments will require squeezing or at least not wasting someplace else.

Some assume that network optimization is about closing facilities, hub and spoke, or some other consolidation scheme as in the previous example. In fact, it is about the optimal allocation of resources to meet customer needs. Customer requirements still tend to outpace distributor compensation, so the focus is not necessarily about reducing the distributor’s footprint, as it were, but about meeting those requirements as efficiently as possible.

An auto parts distributor was an excellent example of optimizing without closing facilities. The firm served car dealers and had grown rapidly with a highly effective business model. At the time of the network analysis, the firm was delivering twice a day in some markets, daily in others, and every two days in others. Multiple daily deliveries were very expensive in terms of trucking and human resources, so the firm wanted an analysis that would examine new markets for them to grow into and a service versus cost analysis of existing markets to determine if the number of deliveries could be safely reduced in some cases. The analysis showed a need for only one or two new facilities (the present network was very efficient) and made recommendations on service offerings going forward. Sample results can be seen in exhibit 2.

Since network optimization configures the distributor’s service offering, it moves huge resources like facilities, changes customer allocation to operations, determines transportation needs, places inventory and other value processes, and sets customer service levels. The decisions in a network optimization will determine the ability to operate profitably, achieve target ROI, improve cash flow, and optimize growth opportunities.

The process has been and continues to be conducted by best practice wholesaler-distributors, but most distributors are not utilizing network optimization. This lack of adoption puts distributors at risk as suppliers choose their channels to market and customers choose their suppliers. For this reason, network optimization will be further explored to establish more distributor best practices in the upcoming Council for Research on Distributor Best Practices consortium on the topic of “Optimizing Distributor Growth & Market Share.” To learn more and to join this new consortium, go to http://www.naw.org/crdbp/growth.php.

2010-03-02T08:57:00.000-08:00

Best Practice: Technology and Change Management

By Dr. Arunachalam Narayanan, Texas A&M University

and Dr. F. Barry Lawrence, Texas A&M University

Technology implemented and utilized properly is a tremendous asset to any wholesale distribution company. Distributors demonstrate the vast differences in technology adoption indicating many opportunities to implement best practices.

Technology is used for both data capture and systems integration. A company without a good data capture (barcode or RFID) can still utilize technology at the systems integration level (like ERP). The Council of Supply Chain Professionals (CSCMP) conducts an annual survey of supply chain professionals on critical issues pertaining to supply chain. Information technology (IT) and supply chain integration always stand out among the top three challenges for the community. Over the last 3 to 4 years, there has been a shift in the challenge, from just technology and integration to “information leverage.”

This is an important change in perception. In today’s environment, almost all companies have either recently implemented an information system or are in the process of selecting and implementing one. The next step is in understanding how to utilize the system for competitive advantage. Success or failure of the system depends on the ability of the company to utilize technology.

The technology failures of the 1990s are now largely behind us. At that time, firms often reported many disasters and took 3 to 4 years to get their systems functional and 7 to 10 additional years before feeling happy with the change. Recent implementations look a lot better. Distributors adopting new systems now report 2 years of pain and a general satisfaction thereafter. Bolt-ons for significant processes like pricing are now common. In general, the cost of IT adoption or changes has plummeted in recent years. Distributors are giant information machines, so the need to effectively adopt, integrate, and manage systems is not optional, it is the only way to do business.

The popular-selling NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and return-on-investment (ROI). These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we have introduced a best practice and how it can improve earnings and/or ROI under current economic conditions. We encourage you as you participate in this blog to ask questions, debate results, and offer your own experiences with such practices, so that we may further the knowledge of the community and the understanding of the science of distribution.

The book breaks business processes into seven groups (SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING, and SUPPORT SERVICES) based on various distributor asset categories as shown in exhibit 1. The support services group includes human resource management, finance, and technology. This month, we focus on technology, especially systems integration, which is a process under support services. In future posts, we will explore best practices in data capture.

Best Practice: Information Management

Effective information management requires system integration. System integration is one of the many challenges in the IT domain for regional and national distributors. For firms with an aggressive acquisition growth plan, it is essential to integrate systems across the company to realize potential efficiency targets. System integration enables branches and regions to share key distribution resources, such as inventory. It also enhances operating efficiency and enables the firm to become competitive by reducing the cost to serve. The branches/regions will have better visibility, leading to higher productivity and the ability to share internal best practices through improved communication.

System integration directly affects the critical attribute—data integrity—that affects many financial elements. For instance, data integrity is one of the key reasons for an inventory write-off. At times, data integrity causes the wrong tactical or operational decisions that lead to financial losses in terms of write-off or constrained cash flow.

The practice levels for system integration are as follows:

COMMON practice: Individual legacy systems across regions (with little or minimal integration)
GOOD practice: Partial integration across key distribution functions
BEST practice: Bringing all the systems to one platform after taking care of local challenges

A fencing distributor was an early ERP adopter. By the mid 1990s, its system was running effectively and the company was exploring ways to leverage it further. An opportunity came when the company needed to remove inventory from a branch to improve its ROI. The sales force estimated a 40% decrease in sales, which was very reasonable given that 25% of sales were over the counter (retail), and the company believed another 15% would be lost when those customers stopped using fleet deliveries as well. After removing the inventory, however, the branch had a 25% increase in sales! The reason was that product was now coming from a regional distribution center (RDC) that carried a $7 million inventory compared to the branch’s original $600,000. The most important component, however, was the ability of the branch to see the RDC’s inventory in the fully integrated system.

The key benefits of system integration are

improved communication
visibility
productivity
asset efficiency
data integrity.

Many companies use “bolt-on” applications. When acquiring new companies, especially at a rapid pace, it’s easier to keep the systems in place, and not too expensive to have an internal programmer create an interface for the bolt-on system to talk to the main system. While one system obviously can’t do it all, this is not an effective long-term solution. When you have too many different software systems, you are not using the full potential of each one, and you may have to run too many interfaces. You may also run into the problem of updates and resource issues. Consider upgrading your laptop running Windows XP to Windows 7. You have to make sure all the other applications are either reinstalled or updated. The same applies for a company. The only difference between the company’s IT infrastructure and a laptop is that instead of an operating system, it’s your enterprise system and instead of applications, it’s your bolt-on.

In the search for a new information system, due diligence requires forming an internal team and hiring outside experts and consultants. The members of the internal team are crucial in deciding the needs of the new system. The team should consist of employees from all related departments, regardless of whether the department actually uses the system or not. A list of possible software systems for any application in an industry is now easily available thanks to the Internet and industry associations. The Distribution Software Guide is one example and can be found at http://www.software4distributors.com/downloads/2010_Distribution_Software_Guide_Email_Blast.pdf.

Post Installation

The other biggest issue in information management is managing expectations. An IT system is not a “magic pill” to solve the problem. Instead, it’s a tool to help achieve certain goals. An interesting survey in CIO magazine (2003, http://www.cio.com/article/29894/The_Value_of_Enterprise_Systems) demonstrates that the major benefits come to those who wait (exhibit 2).

Exhibit 2.

Our interactions with distributors also reiterate the facts of this survey. Patience is key in an IT system implementation. Projects such as these usually have the tendency to exceed budget and timeline. The most obvious place for cutting corners is training and testing, which is a dangerous game, since training is by far the most important and time-consuming part of any system change.

The training challenge has been played out so many times at so many firms. A roofing distributor illustrates this problem. An early adopter of ERP, this distributor did not allocate enough funding for training. Instead, it went with “train the trainer.” The company sent its most capable specialists in functional areas, who had shown an interest in the system, to training at the IT firm. These individuals would then be expected to come back and train others. The problem was that these people still had a job, would be expected to troubleshoot problems for the company, and also conduct training. It was an impossible workload. Then, of course, these specialists were hired away by consultants because of their new skills.

Change Management

A systems integration project leads to a complex change within a company. Ambrose’s 1987 recipe for successful change (Managing Complex Change Pittsburgh: The Enterprise Grp Ltd.) still holds true today. His recipe for change identifies five critical elements: vision, skills, incentives, resources, and action plan. Lack of even one of these elements may lead to confusion, anxiety, frustration, false starts, or slow change as shown in exhibit 3.

So even after more than 20 years of IT implementation, we can say that the greatest potential is still ahead of us. Whether it’s inventory or customer relationship management, warehousing or sales force effectiveness, transportation or customer service efficiencies, all roads lead to the distributor’s information systems. The IT system will define the relationships and operations of the next generation distributor. The next generation will be automated; connected to customers and suppliers; and every asset, human resource, and customer will be wired in (wirelessly).

2010-02-02T08:19:00.000-08:00

Best Practice: Fleet Cost Management

By Dr. Barry Lawrence, Texas A&M University

Senthil Gunasekaran, Texas A&M University

Pradip Krishnadevarajan, Texas A&M University

Transportation is a key wholesale distribution function, in terms of cost and customer service. In some lines of trade, distributors spend more than a third of their gross margins on transportation services. Optimal transportation management is essential to maintaining profitability and gaining a competitive advantage. It carries an even greater importance when you own or lease your transportation fleet. Although private fleets are more expensive, they are sometimes necessary for providing quality customer service. The various processes in transportation management are shown in exhibit 1.

Key findings from a transportation study conducted by Texas A&M University in collaboration with FedEx for the Industrial Supply Association in 2006 (Texas A&M, FedEx, and ISA, 2006), are as follows:

Cost ranked first. Cost was the top concern regarding the transportation function then and for the next three years, superseding customer service and reliable delivery times. Cost was the most important factor in choosing a transportation provider.
Technology investment should be leveraged. Technology had finally come to transportation, as many survey respondents said they were using some sort of shipping system. However, most respondents did little more than process orders or pass along invoices and material safety data sheets. Far fewer used IT for any other function, including tracking carrier performance.
Planning makes a difference. Companies with a formal strategic plan for their transportation function outperformed others. After analyzing the data, one key variable pointed to both a low transportation cost and high customer service level: having a plan for the transportation function. Those respondents with a transportation plan reported lower transportation costs as a percentage of revenue and a higher on-time delivery rate than those companies without a plan.

Compounding these findings, companies that had transportation plans had, on average, more movement of product from supplier to customer than those companies without a plan—a fact that should have resulted in higher transportation costs.

The NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and ROI. These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we have been introducing a best practice and how it can improve earnings and/or ROI under current economic conditions. We encourage readers to ask questions, debate results, and offer their own experiences with such practices so that we may further the knowledge of the community and the understanding of the science of distribution.

The book breaks business processes into seven groups (SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING and SUPPORT SERVICES) based on various distributor asset categories as shown in exhibit 2. This month, we focus on the SHIP group. The SHIP group has seven processes, and we are discussing “fleet cost management” in this blog post.

Best Practice: Fleet Cost Management

An automotive distributor delivered parts to car dealerships. Their market-entry strategy was to provide two same-day deliveries for metro customers/dealers. Over time, the distributor’s inventory management practices deteriorated due to the market strategy. The dealers began relying heavily on the two same-day deliveries and stopped stocking a wide range of parts. This raised the question about the benefits of the two same-day deliveries service; whether it contributed to additional revenue or led to an enormous increase in safety stock / inventory at the distributor’s warehouses. In order to understand the impact of two same-day deliveries service, the distributor began focusing on fleet cost management.

In general, a fleet cost management process consists of two analyses: cost per mile (CPM) analysis and break-even analysis. The practice levels for this process are as follows:

COMMON practice: 1) No CPM calculation is performed 2) Cost groupings at asset level

GOOD practice: 1) Measurement based on major cost categories such as leasing and fuel

BEST practice: Comprehensive methodology that defines two major cost components: 1) Fixed components—leasing, depreciation, insurance, misc., and 2) Variable components—fuel, driver salary and benefits, maintenance, rental

Let’s first look at CPM analysis. This process focuses on identifying cost per mile components and determining the contribution of each component. Best practice recommends data be input into the system to track the following metrics for better decision making:

Fixed cost breakup
Leasing: tractor and trailer
Depreciation: tractor and trailer
Insurance
Miscellaneous: licensing, citations, taxes, and so on
Variable cost breakup
Fuel
Driver salary and benefits
Maintenance: tractor and trailer
Rental

Both fixed and variable costs are a part of CPM analysis. Considering these costs separately (fixed and variable cost components) can be helpful in designing any cost control measures. CPM analysis is important because this metric drives many critical decisions, such as owning a fleet versus using a third-party carrier. This number can be used to benchmark the firm with the industry. A sample breakup of cost per mile components for a building materials distributor is shown in exhibit 3.

Now, let’s look at break-even analysis. This provides information about the number of miles that has to be traveled by private fleet vehicles to equal the cost of for-hire service. This information allows you to determine which option (private fleet versus for-hire) is most cost effective. A major challenge is that all these analyses are unique to each organization, depending on their business processes. Proper consideration should be given to the level of customer service required, transportation costs, and benefits. Exhibit 4 compares the cost of a private fleet (for company X) with the available cost per mile market rates from various carriers (ranging from 1.25 to 2.25) based on a break-even analysis of one firm’s freight data. The initial investment for the private fleet is indicated as the fixed cost. It also indicates the number of miles that have to be covered in case there are various carrier selections. For instance, company X’s cost line crosses the cost line of a carrier (providing 1.75) at 53,474 miles. This shows that the carrier rate is economical if company X plans to drive less than 53,474 miles. In general, it would be beneficial for a firm to benchmark itself against the market and improve accordingly.

Getting a Handle on 3PL Costs

A large distributor serving small contractors found transportation management to be especially challenging. The distributor maintained its own fleet, but also hired trucking services for deliveries that cost millions of dollars. Company managers found it nearly impossible to keep track of the transportation carriers that the branch operations staff called on, and they also questioned whether their freight bills were accurate. Freight bills are often inaccurate for a few reasons:

Carriers are often under contract to give a firm discounts under some sort of schedule. However, many times the freight bill may not reflect these discounts.
If a product carries a lot of risk—for example, it is high-value, fragile, contains hazardous materials, and so on—the freight carrier charges a higher rate. Often, warehouse people will lose the distinction between different rates and send all products at a higher than necessary rate.

To prevent paying excessive freight bills, this distributor employed an outside specialist to do freight bill auditing. The process eliminated a lot of expensive errors. Soon the auditing firm began negotiating freight contracts for the distributor, since they had developed expertise in working with the trucking firms. Questions arose soon, however, when branches discovered that the only freight errors the auditing firm was discovering anymore were from trucking companies that had not signed contracts with them. Trust began to erode between the distributor and the auditing firm and in time the relationship broke down.

Capturing 3PL costs and tracking metrics is vital in transportation management. The opportunity to create cost savings exists whether transportation is outsourced or not, and distributors are among the world’s largest transportation customers. Not understanding cost structures and how to manipulate routes will decrease net margins. Distributors need to apply more science to this practice.

2010-01-05T10:36:00.000-08:00

Best Practice: Process Improvement

By Dr. Barry Lawrence, Texas A&M University

Senthil Gunasekaran, Texas A&M University

Pradip Krishnadevarajan, Texas A&M University

Warehouses form a critical component of the supply chain; as a result, their design and management determines the strength of the supply chain and makes the flow more transparent. Warehouses can also be referred to as the backbone of a supply chain. In the 1990s, companies focused on inventory management because inventory represented such a large asset on the distributor’s books. With the rise of acquisitions, distributors changed their focus to network optimization, facility consolidation, new location identification, and so on. The emphasis was on getting the right number of warehouses in the right places. The next step was to optimize the internal workings of these facilities (called warehouse optimization). We will see this cycle (inventory, network, and warehouse) repeated again and again as acquisitions rise and fall with business cycles.

The four primary resources to any company are inventory, human resources, accounts receivable, and facilities. Inventory, accounts receivable, and human resources have some flexibility and can be reduced or increased at a quicker pace than facilities or other more fixed assets. Most distributors consider facilities to be the most critical of the four resources, because you need the “space” to support your other assets and sustain your business. Warehouse fulfillment is composed of key inbound processes tied to receiving, staging, and put-away. Cycle counting, product placement, location type, location identification, and storage are all related to these activities. Process improvement can be applied to any of the warehouse processes. Distributors have made little progress in improving most of the warehouse processes, primarily because it’s difficult to determine the return-on-investment (ROI) associated with any type of warehouse process improvement.

The NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and ROI. These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we are introducing a best practice and how it can improve earnings and/or ROI under current economic conditions. We encourage readers to ask questions, debate results, and offer their own experiences with such practices so that we may further the knowledge of the community and the understanding of the science of distribution.

The book breaks business processes into seven groups (SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING and SUPPORT SERVICES) based on various distributor asset categories. This month, we focus on the STORE group (see exhibit 1). The STORE group has eight processes and we’ll discuss process improvement.

Best Practice: Process Improvement

In general, process improvement techniques seek to increase process efficiency or throughput. Processes tend to remain status quo if there are no discernable problems. In many cases, we get so used to the process we have been using for years that we fail to recognize and often overlook any improvement opportunities. Many companies bring in lean experts to help identify opportunity areas and train people to use lean tools. This approach has been highly successful, since external experts tend to think “outside of the box” and are not bound by a company’s existing practices.

Process improvement techniques are gaining popularity among distributors, but they often are not applied correctly. The practice levels for process improvement are as follows:

COMMON practice: 1) Local efficiency (2) Efficiency focus (regardless of effectiveness) (3) No SOPs (Standard Operating Procedures) (4) Customer driven process improvement efforts

GOOD practice: (1) SOPs (2) 5S approach—Sort, Stabilize or Systematize, Shine, Standardize, and Sustain

BEST practice: (1) Value stream mapping (VSM) (2) Lean and six sigma (lean focuses on speed and six sigma focuses on accuracy) (3) Theory of constraints (TOC) (4) Cause and effect (5) 5 Whys

Exhibit 2 shows a lean implementation framework developed by researchers at Texas A&M University to assist distributors in process improvement (lean and six sigma) activities.

The 10-step approach is as follows:

Any lean initiative should begin by identifying a problem/opportunity area where focus is required. The problem area could be in any area, such as warehouse management, inventory management, demand management, logistics, and so on.

Metrics must be defined to track the benefits of switching to a redefined process.

Once metrics are defined, a detailed current value stream map (VSM) of the process under consideration should be performed along with a sample time study. If multiple people perform the same process, time studies must be done for each individual and an average time can be used in the VSM.

Prior to drawing up a VSM for the future state of the process being studied, lean concepts such as cause and effect, the 5 whys, and so on, must be applied to get to the best scenario of a future-state VSM. Brainstorming with process owners is critical to the success of this activity.

The metrics defined in step 2 need to be captured again to see what the changes between “as-is VSM” and “to-be VSM” are, in order to justify moving to a redefined process.

When lean improvements are performed, many opportunities are identified along the way; therefore, steps 2 to 5 should be performed for all the processes under consideration.

Once to-be VSMs are drawn up for all processes, distributors are faced with an important question: How do you prioritize the improvements during the implementation phase? A few factors to consider are ease of implementation, probability of success, ROI, risk, resource requirements, timeline to implement, and so on.

It’s also important to create relevant documentation of any improvements. This is for future reference/analysis, developing standard operating procedures (SOP) for new hires, safety documentation and training, and performance reporting.

Sharing documentation with other levels and locations of the organization helps standardize the processes and allows the firm to adopt best practices to get to higher efficiencies.

Continuous improvement is critical to the survival of any business venture. The lean framework is applied again from step 1 to keep improving operations further. New areas are targeted for the lean exercise. A customer value-add (CVA) activity at the end of the study might seem like a business value-add (BVA)or non-value-add (NVA) activity after a period of time due to changing customer needs, market conditions, and the advent of new technology.

Best Practice in Action: Do Process Improvements Work?

An electrical distributor projected significant increases in sales for year 2006. Sales had been growing in previous years and the distributor’s warehouse was not expected to handle the projected sales growth of 2.5% for 2006. The company’s CFO started talking to facility lease agencies to identify a new facility. The vice president of supply chain told the CFO that they could handle increased sales with the current warehouse by increasing the efficiency of warehouse processes. The CFO did not believe it would be possible. The vice president of supply chain put together a project team to study warehouse processes—product placement, efficient storage equipment, and material handling equipment. The project team developed an implementation plan based on the 10-step framework and demonstrated how it could handle increased sales. The CFO was convinced, and the distributor is still operating out of the same facility. The vice president of supply chain demonstrated the power of warehouse process improvements when deployed appropriately.

The distributor also applied task interleaving for the cycle counting process to increase cycle count/inventory accuracy and increase productivity (number of lines counted per hour). The increase in accuracy will reduce inventory write-off expenses and improve customer service. This will affect the income statement and hence EBITDA. The schematic diagram to quantify cycle counting using task interleaving is shown in exhibit 3.

The distributor also used task interleaving (the process of combining two or more activities) to improve warehouse efficiency. The fast-moving items (A and B) are most frequently accessed. The more times a product is touched, the greater the opportunity for error. The distributor decided to combine cycle counting for A and B items with the put-away process. Each time the A and B products were put-away, the operators performed cycle counting and resolved discrepancies immediately. This procedure increased overall inventory accuracy and customer service. The frequency of counting A and B items was once in two weeks, and they constituted about 10% of all the stock items. Through task interleaving, the distributor experienced annual savings from write-offs and expenses of $100,911 and $47,314 respectively—a 6.6% reduction in total warehouse expenses.

2009-12-01T08:29:00.000-08:00

Best Practice: Distributor Resource Alignment Analysis

By Dr. Barry Lawrence, Texas A&M University

Senthil Gunasekaran, Texas A&M University

Pradip Krishnadevarajan, Texas A&M University

Distributors choose a customer type and then array resources (inventory, facilities, transportation, people, suppliers, etc.) to meet that customer’s needs. The previous blog posts discussed inventory, customer, and supplier stratification. Stratification is the critical decision for how resources are to be deployed. Prioritizing how customers will be supported and which customers to focus on are keys to profitability. Poorly deployed resources lead to low return-on-investment (ROI). Low ROI ultimately leads to business failure.

This blog post addresses how wholesaler-distributors “invent” themselves by determining what investments will be necessary to be successful. The key resources—inventory, customers, and suppliers—come together to form the distributor’s service offering. Distributors next develop strategies for each inventory/customer/supplier combination. Most distributors do this alignment in some form or fashion, but it is carried out informally. Informal systems are rarely optimal. Best practices dictate a more structured approach.

The new NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and ROI. These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we are introducing a best practice and how it can improve earnings and/or ROI under current economic conditions. We encourage readers to ask questions, debate results, and offer their own experiences with such practices so that we may further the knowledge of the community and the understanding of the science of distribution.

The book breaks business processes into seven groups (SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING and SUPPORT SERVICES) based on various distributor asset categories. This month, we focus on aligning supplier, inventory, and customers as part of SUPPLY CHAIN PLANNING as shown in exhibit 1.

Best Practice: Distributor Resource Alignment Analysis

On a field trip to a popular ice cream manufacturer, a group of graduate students asked the operations manager if the firm had ever had a stock out on their best-selling product vanilla ice cream. He said it had never happened in his time there and that he didn’t want to be there if it ever did. The students were surprised because a 100% fill rate should be impossible—especially for a perishable product, since large inventories would result in obsolescence problems.

A tour of the plant made things clearer. The operations manager pointed to the company’s five manufacturing lines. He said that two ran vanilla and the other three ran all other flavors. The three multiflavor lines could be changed over after cleaning the equipment. The students saw how the 100% fill rate was possible: if there was a chance vanilla could stock out, all five lines would be running vanilla. The solution was to align supplier resources (the manufacturing lines) with the “A” item (vanilla ice cream).

But the operations manager had not told the whole story. As far as the manufacturing operations were concerned, vanilla would not stock out. Once on the truck, however, the firm faced a new challenge. The truck would make a run and might encounter higher than expected demand at customer operations. The driver would allocate the product based on serving the most important customers first and giving smaller amounts to the smaller customers.

The process aligned supplier resources (the manufacturing lines), with the top selling product (vanilla) and core customers. Managing relationships between core customers, “A” inventory and supplier resources are a fundamental part of managing the supply chain. Since no firm can do everything, it is critical to match what matters most up and down the supply chain. The alignment model is shown in exhibit 2.

Based on previous blog posts, here are the different inventory, customer, and supplier groups:
1) Inventory – A, B, C, and D
2) Customers – Core, Opportunistic, Marginal, and Service Drain
3) Suppliers – Strategic partners, Distributor controlled, Out of control, and Vendor controlled

There are about 64 possible combinations based on the above stratification segments. Let’s discuss a few common inventory-customer-supplier combinations and discuss appropriate strategies.

A building materials distributor was running a small door manufacturing plant. The manufacturing plant would buy the “slabs” (the door) and then install windows, hardware (door knobs, hinges, screws) and “hang” the door (put it in its frame). The process was labor intensive and did not allow for high volume operations, since the doors were sold to custom builders and could not be forecasted well. Buying the slabs offered three alternatives: (1) buy the slabs twice a year at a truckload discount (less expensive), (2) buy the slabs three or four times a year at a less than truckload (LTL) rate (more expensive), or (3) buy the slabs for next-day delivery in exact amounts from another distributor (most expensive).

Upon investigation, they found that buying at a truckload rate built huge inventories not justified by the discount. Following the same logic, they found that buying at LTL also created too much inventory. They were about to settle on using the distributor when they discovered that this distributor could deliver the doors completed with hardware and hung. The other distributor was so efficient that it was more cost effective to buy the complete door and close down their door shop.

From a resource alignment perspective, the distributor had a core customer who needed the doors so they had to provide them. The individual doors, however, did not rise to “A” inventory status, since they required too much inventory for too many different configurations. The solution of postponing the final configuration (doing your own door manufacturing) was also not effective since the doors did not command sufficient margins and did not have sufficient volume to allow for efficient purchasing and manufacturing processes. The doors were important to the core customer, however. To properly align resources, the distributor eliminated value add (inventory and manufacturing) on the doors and found a strategic supplier that could support that part of the business, so they could continue to invest in their “A” inventory (molding, trim, etc.).

Resource alignment requires understanding that manufacturing resources are not flexible and require a tremendous investment. Manufacturers of commodity items (low cost, low mix, high volume) require high volume to make up for low margins. Distributors have to smooth out demand and uncover as much business as possible (find and maintain core customers). Their investment in inventory has to be low due to their own low margins, and their market coverage has to be strong. Manufacturers of specialized, high-technology equipment need distributors to be willing to “take a chance” and bring on new items without fully knowing whether they’ll succeed. They must buy in large enough amounts to get manufacturers to sufficient volumes fast.

Electronics distributors meet this challenge by buying new items and then debiting obsolescence costs back to manufacturers. Products decline in value so fast that distributors would be cautious to buy new products in large amounts. The solution is for distributors to buy enough to make manufacturers successful. Then as prices decline with manufacturing efficiency, they can document and debit back to manufacturers. The process allows for manufacturing efficiency and distributor profitability.

Such an arrangement requires alliances with suppliers (strategic partners) and well-understood customers (core customers). Only with this type of arrangement can distributors make the right decisions on the right “A” inventory to align the supply chain.

About this Blog

“Managing in an Uncertain Economy” is a blog created by the Council for Research on Distributor Best Practices (CRDBP). The mission of the CRDBP, created by the NAW Institute for Distribution Excellence and the Supply Chain Systems Laboratory at Texas A&M University, is to create competitive advantage for wholesaler-distributors through development of research, tools, and education. CRDBP encourages readers of this blog to send in comments and e-mail this blog to other interested parties.

2009-11-03T10:13:00.000-08:00

Best Practice: Supplier Stratification

By Dr. Barry Lawrence, Texas A&M University

Senthil Gunasekaran, Texas A&M University

Pradip Krishnadevarajan, Texas A&M University

and Dr. Malini Natarajarathinam, Texas A&M University

Distributors choose a customer type, the “core customer” as described in earlier blogs, and then arrayed resources to meet that customer’s needs. In the process, the distributor “invents” itself and determines what investments will be necessary to be successful (inventory, warehouse, equipment, human resources, etc.). One of the earliest and most important decisions is supplier selection.

Suppliers are selected based on their ability to serve the core customer. In the beginning, this is a very positive relationship with the distributor seeking to delight the customer, and the supplier seeking to find new ways to penetrate this new market. Over time, however, the relationship matures and sometimes goes awry. Suppliers may want distributors to broaden their offerings or buy in volumes inconsistent with what the core customer needs, often leading to excess and obsolete inventories. In other cases, supplier performance may decline or not keep up with the market, leading to customer service failures or a need for more inventory investment.

Many best practices have been developed in Supplier Relationship Management, but they are often misdirected in practice. One distributor maintained what the staff called a supplier report card (a well-known best practice). When asked how they used the report card, they said they took it into their pricing negotiation meetings each year with the supplier. This is not a report card; it’s a baseball bat.

The issue surrounds the basic definition of the distributor’s role in the supply chain. Some believe the distributor is the supplier’s customer, while others say the distributor is the supplier’s partner. The distinction is important. A customer is one to be served; a partner collaborates for the betterment of all. A customer seeks to optimize his or her own costs and operations without regard to the supplier’s needs. A partner, on the other hand, acts as the channel to market for his or her key suppliers and facilitates the success of both.

Returning to our original premise, the distributor selects suppliers based upon their ability to support the needs of core customers. The most significant (strategic) suppliers should carry products and skills that set them and the distributor apart. These suppliers must be partners. The ones that fill the small holes in the product offering and are only differentiated by price and by not product features or quality are vendors. To them, the distributor is a customer.

The new NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and return-on-investment (ROI). These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we continue to introduce a best practice and how it can improve earnings and/or ROI under current economic conditions. Using this blog, we encourage you, our readers, to ask questions, debate results, and offer your own experiences with these best practices, so that together we may further the knowledge of our community and the understanding of the science of distribution.

The book breaks business processes into seven groups (SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING, and SUPPORT SERVICES) based on various distributor asset categories. This month, we focus on the SOURCE group (see exhibit 1). The SOURCE group has five processes, and we’ll discuss “supplier stratification.”

Best Practice: Supplier Stratification

The process of stratifying suppliers based on profitability, distributor services, performance, and loyalty is called supplier stratification. Other factors such as risk, relationship, and growth potential can be used as well. The analysis is spread across all suppliers or it can be limited to the suppliers that account for 80% of annual spend. The objective of supplier stratification is to understand the criticality of the supply base and to allocate key resources accordingly. The stratification helps develop relationships and improve profitability in the long term. Supplier stratification helps the sourcing team see the impact of buying activity on the firm’s profitability.
Supplier stratification techniques are gaining popularity, but they are often not applied correctly. The practice levels for supplier stratification are as follows:

COMMON practice: (1) No formal supplier stratification, (2) Based on purchase price variance and landed cost

GOOD practice: Based on a single factor (1) Volume of Spend $ (Cost of Goods Sold), (2) Pareto Framework (80-20 rule)

BEST practice: Based on multiple factors (1) Profitability, distributor services, supplier performance, loyalty (exclusivity vs. general), risk/exposure, (2) Combination method. A combination method developed by Texas A&M is shown in exhibit 2.

The stratification framework summarizes key supplier relationship factors in a supplier stratification model based on four factors:

profitability
performance
loyalty
distributor services.

Based on these factors, suppliers can be grouped within four categories:

Strategic partners: These suppliers represent strong brand, exclusivity, solid delivery capability, and, together with the distributor, high market control. Profitability is high with this group because sales and margins are high and the cost of doing business is low. Strategic suppliers help distributors sell with their strong brand recognition, at good margins through the exclusive channel, at lower cost-to-serve due to better deliveries, and with greater control of the market by leveraging the alliance.
Vendor controlled: These suppliers represent high service intensiveness and low market control, in addition to strong brand and exclusivity. The cost of doing business with this group is high for required services (repair, consulting, programming, and so on), but the suppliers are efficient and don’t drive up logistics and inventory expenses. These suppliers offer exclusivity, but demand high loyalty and good performance to protect their brands. Distributors should seek to develop a more balanced relationship that allows them to determine what services the customer needs and not be dictated to by the supplier.
Distributor controlled: These suppliers represent those situations in which the supplier’s brand is weak, but the distributor’s presence in the market is unchallenged. The distributor is able to dictate service levels and manage prices. Although this is an attractive area, it usually is not sustainable for long because the competition will soon arrive. The distributor should help the supplier improve its performance and increase its loyalty or find another supplier that will.
Out of control: These suppliers are opportunistic, but they are unwilling to shoulder any of the burdens in establishing and maintaining a market. Distributors should quickly discontinue these relationships.

Distributors want to do business with strategic suppliers. They want loyal/high-performing, vendor-controlled suppliers that can become more effective and loyal in a distributor-controlled environment, and then use the rest of their resources to penetrate new markets. Distributors might have to do business in the rest of the vendor-controlled area due to customer requirements to carry a brand. They also may have to do business in the distributor-controlled area to capture profitability, as well as in the higher end of the “out of control” area just to hit necessary sales numbers. From the start, however, distributors definitely should get out of the worst “out of control” business so that they can keep from losing resources for very poor ROI.

Even though supplier stratification processes influence many business factors, such as brand, exclusivity, and market control, most firms concentrate on two process metrics that affect financial measures:

Growth potential. This determines the supplier’s ability to scale up shipments when the distributor grows its market share and geographic footprint, affecting revenue growth.
Lead time and variability. These contribute to inventory levels, depending on a customer’s service-level requirements. Lead times and their variability are countered by the financial element inventory, reflected directly in the financial statements.

Revenue can measure both revenue growth and total asset turnover (asset efficiency). Inventory can be related to GMROII (profitability), working capital (cash flow), and inventory turnover (asset efficiency). These four financial drivers—asset efficiency, cash flow, profitability, and growth—contribute to shareholder value.

Best Practice in Action: Do Suppliers Respond to Performance Measurement?

In order to perform the supplier stratification as per the Texas A&M combination method, you would need to use four different factors as shown in exhibit 2. One distributor that decided to implement the stratification framework for suppliers began with “supplier performance” (one of the four factors in exhibit 2) to perform an evaluation of its top supplier. The top supplier accounted for about 15% of the distributor’s inventory. During initial negotiations with the supplier, contracts were drawn up based on agreed-to lead time variability. If the lead time is 30 days and the supplier often delivers the product between 25 and 35 days, then the variability is 5 days (the deviation from the lead time of 30 days). However, over the years as the supplier expanded its customer base, the lead time variability became 15 days instead of the initial 5 days (as per the contract). When the distributor discussed this with the supplier, the supplier said the variability would get better over time as the supplier increased capacity. However, this did not happen.

The distributor then wanted to understand the impact of increased lead time variability on its inventory levels and customer service. Due to this variability from the supplier going over the agreed-to 5 days, the distributor had to increase inventory levels by more than 20% so that it could still meet the same customer service levels. This increased its inventory investment, reduced warehouse space for new products, increased interest expenses, and so forth. The distributor was taking a heavy toll on its bottom line. Its financial statements became a key concern for top management and shareholders.

The distributor then began to develop a tracking report for supplier performance. The distributor presented the tracking report to the supplier on a quarterly basis. Keep in mind that this was just a report card, and not a baseball bat. The distributor also made the supplier aware of the additional amount of inventory the distributor needed to carry so that it could still meet customer service levels. The supplier then understood the impact of increased lead time variability on the distributor’s bottom line. In the real world, there are various uncertainties that suppliers just have to plan for. Unfortunately, the supplier could not reduce its lead time variability. However, the supplier compensated the distributor by providing price discounts and increasing the payment terms from 45 days to 65 days. As a result, the distributor was compensated for the increase in supplier’s lead time variability. This did not happen overnight, but the point is that the distributor got the message across to the supplier in a way that was beneficial to both parties.

The process of connecting lead time variability to shareholder value is accomplished using exhibit 3.

Most distributors do not believe that suppliers would respond to a measurement system. We’ve observed, however, that in many cases, a scorecard has turned out to be highly effective. In fact, a majority of manufacturers that we’ve encountered are impressed with their distributors’ attention to performance tracking and, as a result, they are willing to work with their distributors for improvement. Quite a few manufacturers also referred to the performance reporting mechanism as one of the value-added services that distributors could offer in general to all suppliers. The critical questions are

Could distributors offer this performance tracking as a service to suppliers?
Would suppliers value this offering?
Could distributors get compensated for this service?

Moreover, if suppliers respond to your measurement system in a positive fashion, the end result is more than compensation; it is a partnership and sustainability.

About this Blog

“Managing in an Uncertain Economy” is a blog created by the Council for Research on Distributor Best Practices (CRDBP). The mission of the CRDBP, created by the NAW Institute for Distribution Excellence and the Supply Chain Systems Laboratory at Texas A&M University, is to create competitive advantage for wholesaler-distributors through development of research, tools, and education. CRDBP encourages readers of this blog to send in Comments and email this blog to other interested parties.

Best Practice: Sales Growth through Inventory Reinvestment

2009-09-29T08:36:00.000-07:00

By Dr. Barry Lawrence, Texas A&M University

and Dr. Ismail Capar, Texas A&M University

One step forward and two steps back is what it seems at times with this economy. Still, most are starting to look at growth as the next objective. Distributor growth will, in fact, be the next consortium for the Council for Research on Distributor Competitiveness (CRDC), the joint research effort of the NAW Institute for Distribution Excellence and Texas A&M’s Supply Chain Systems Laboratory. The NAW Institute Board of Directors selected the topic even before the recovery began, and the concept is now gaining momentum in the industry.

In last month’s blog, we addressed growing sales from a customer stratification and sales force redeployment perspective. This month we will discuss another growth perspective: Inventory Reinvestment. Distributor growth can be thought of as moving along in three dimensions: organic, vertical and horizontal integration, and expansion.

Organic refers to growing business with existing customers or new ones coming to us through our standard business practices. Strategies surround creating a more effective sales effort and marketing tools.

Vertical integration involves moving up or down the supply chain by taking on manufacturing or retail processes. Horizontal integration refers to taking on new functions like repair or consulting services. Strategies include acquisitions or developing new service capabilities.

Expansion takes on two forms: geographic and product driven. Geographic expansion refers to growing within new territories. Strategies include opening new operations and acquisitions. Product-driven expansion involves new product offerings. Strategies include taking on new product lines from existing suppliers or adding new suppliers. Each of the foregoing expansion strategies requires some sort of investment. Since most firms have limited resources, the strategies require an understanding of how return-on-investment (ROI) will be affected by each strategy. Those growth strategies with the highest ROI should get the scarcest resources. An even more difficult decision requires comparing existing investments to new strategies to potentially stop doing one thing in favor of a new higher ROI opportunity.

The new NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and ROI. These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we are introducing a best practice and how it can improve earnings and/or ROI under current economic conditions. Through this blog, we encourage readers to ask questions, debate results, and offer their own experiences with such practices so that we may further the knowledge of the community and the understanding of the science of distribution.

Best Practice: Sales Growth through Inventory Reinvestment

In our August blog entry, we addressed inventory reduction through best practices like inventory stratification. One approach is to reduce inventory, which eases cash flow problems and improves ROI through reducing the denominator (assets) in the equation. The strategy does not, however, grow sales. Pursued too aggressively, in fact, inventory stratification will reduce sales on C and D inventory and not add any back. Inventory stratification can be performed at branch level—or local ABC—and company level—or global ABC—and combined in a single matrix to determine inventory deployment strategies and business decisions at the company level. Common strategies are:

Increase service levels. If items are A and B at both branch and company level
Review/eliminate. If items are C and D at both branch and company level
Evaluate. If items are A or B at branch level and C or D at company level
Redeploy. If items are C or D at branch level and A or C at company level

World-class distributors receive a 300% or better ROI on their A and B item inventory (based on gross margin contribution). No other investment can give a greater return, so a reduction in inventory to invest in other forms of business does not make sense. The most powerful approach would be to reinvest in A and B inventory. The strategy is organic in nature and requires that the opportunity to reinvest be available.

Reinvestment can take the form of increasing inventory on A and B items to improve their fill rates. A higher fill rate on the most important items will lead to an increase in sales, since fewer stock outs mean fewer lost sales and the resultant higher customer satisfaction level will lead to a greater share of the customer’s business. The process is doubly effective since the high turn rate on A and B items means that the small changes in inventory (lower holding costs) will have a big impact on service levels (lower stock out costs). Properly applied, you can have your cake (lower inventory) and eat it too (increased sales) by significantly decreasing C and D items and marginally increasing A and B items. Best practice purchasing policies are shown in the following figure.

In an interesting example, a distributor for grocery stores was trying to decrease C and D inventory. The company decided to implement a rule that when the purchasing department placed an order, they could not use C and D items to make truckload quantity. Purchasing would have extra space on the truck and would buy larger quantities to make truckload freight rates. Since volume levels on A and B items guaranteed the highest discount possible, purchasing logically took on more C and D items to get discounts there as well. The practice had created large slow-move inventories.

Purchasing, therefore, was forced to use A and B items to make truckload. The company reduced C and D inventory significantly, but was surprised when overall fill rates rose and sales increased as stock outs on A and B items dropped.

An Expansion Example

A number of distributors have used a technique called “storefronts.” The process consists of opening more locations with “A” item inventory only and serving other items from regional distribution centers. Contractor-serving distributors will commonly use this method to combat the “big boxes” (retailers). The distributor’s advantage comes from more locations closer to the customer coupled with a professional sales force. Retailers follow a similar strategy of “A” item inventory only, but they do not field as strong a sales force.

The inventory requirements are minimal since the storefronts can be replenished from a central warehouse on almost a daily basis along with slow-move items not carried by the storefront. As a result, facilities can be kept very small. The process allows for high sales with fewer assets (high ROI). The decreased need for inventory assets frees up resources to open more storefronts (geographic expansion).

An Integration Example

Integration has failed many times when manufacturers have purchased distributors. Distributors have a slightly better record when they add light manufacturing. Common examples have included building materials distributors who take on paint mixing lines (vertical integration). Fluid power distributors often will carry out systems integration responsibilities by building larger, more complex or specialized, power units from products they already carry (horizontal integration).

Integration takes advantage of assets already in place to add a new function or service. It often fails when the new process is performed poorly (not a core competency) and ROI requirements are not achieved.

Home Depot attempted horizontal integration when it purchased Hughes Supply. When the firm added distribution as a function, it found that the new division, HD Supply, could not meet the firm’s ROI requirements, and so they were forced to sell it.

Reinvesting

Inventory strategies allow for many reinvestment opportunities. If nothing more can be done with existing A and B items and no new products can be added, other forms of expanding inventory impacts, like storefronts or integration, can be employed. Whatever the choice, ROI is king and failure to optimize it guarantees failure. The following exhibit describes the link between stratification and shareholder value.

Best Practice: Customer Stratification

2009-09-01T07:10:00.000-07:00

By Dr. Barry Lawrence, Texas A&M University

and Dr. Malini Natarajarathinam, Texas A&M University

Well, the indicators are turning green. Experts say we’ll look back on July and August as the beginning of the recovery. Still doesn’t feel like it though. One distributor related a familiar story about how his suppliers and customers are coming together to paint a rosy picture. Competitors have folded up, and customers are seeing new orders. Suppliers are making deals for consignment inventories and transferring new territories to the distributor as well. The problem is banks are about to call their notes, and they may not make it through the month much less capitalize on the opportunities.

Even those strong enough to weather the remaining few months of the storm face challenges. Competitors have been beaten down; customers are anxious to get back into the game, but few have money for even the basics. Consumers have to clear higher hurdles to get mortgages, and contractors are having a difficult time borrowing money to start jobs even when homeowners have the mortgage. Consumers are cutting corners and tucking money away so all the old rules about who has money and who is spending are out. Still, as one distributor put it, one thing is clear: Increasing sales is the order of the day.

The new NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and return-on-investment (ROI). These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we will introduce a best practice and how it can improve earnings and/or ROI under current economic conditions. We encourage readers to ask questions, debate results, and offer their own experiences with such practices so that we may further the knowledge of the community and the understanding of the science of distribution.

The book breaks business processes into seven groups based on various distributor asset categories. The 7S process group includes SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING, and SUPPORT SERVICES as seen in Exhibit 1. This month, we focus on the SELL group. The SELL group has eleven processes and we’ll discuss customer stratification here.

Best Practice: Customer Stratification

Customer stratification may sound like an odd idea in a climate where any paying customer is a good customer. Still, the sales force has two issues to deal with: First, who do I call on that has a chance of giving me an order and paying for it? Second, who should I be calling on, and how do I secure relationships that will still be worthwhile when the economy takes off?

Customer stratification answers these questions and many other, perhaps more important, ones. Customer stratification measures how much business a customer does with us (sales), how profitable they are in gross margins, how loyal they are, and how costly they are to serve (to protect net margins). Each of these dimensions has a bearing on the sales force’s questions.

Customer stratification techniques are gaining popularity, but they often are not applied correctly. The practice levels for customer stratification are as follows:

COMMON practice: 1) No defined customer stratification (2) Customer groups based on market type or product line (3) Top customers based on revenue

GOOD practice: Based on a single factor (1) Volume [sales $] based (2) Gross margin (3) Business potential

Volume (sales) is critical to achieve economies of scale. The fact that gross margin customers are willing to pay in down times says a great deal about what they’ll do in up markets. Beggars can’t be choosers, but given the choice of calling on high- margin versus low-margin customers is a no-brainer.

BEST practice: Based on multiple factors (1) Cost to serve, customer loyalty, business potential, profitability, and relationship (2) Combination method

Loyalty is important since replacing customers and chasing customers who come and go is expensive. Finally, cost-to-serve will overwhelm the gross margin if the customer drives services through the roof. In a down market, the sales force may give away services easily just to capture short-term sales. There are long-term consequences for these decisions.

Customer stratification can be used in conjunction with other best practices. Pricing is an obvious one. Sales force redeployment is another. Pricing decisions include many factors but essentially they start with the customer and the nature of the relationship. Sales force redeployment determines not only which customers the sales force will call on, but how much time they will spend with each and the nature of that discussion.

Pricing

One distributor set up a pricing methodology to increase its margins. A key part of the strategy was customer stratification. When quoting, the salesperson would open a screen that gave a recommended price based on customer stratification, item stratification, unit cost, previous margins, and customer-item visibility. The last four items came from the system’s data and were undeniable. The key issue was the customer’s status.

The distributor’s screen listed the customers according to the stratification as Core, Opportunistic, Service Drain, and Marginal. These terms come from Pricing Optimization research at Texas A&M University (see Optimizing Distributor Profitability at http://www.naw.org/optimizdistprof for a complete description of the Customer Stratification technique and how to implement it). The customer stratification model is shown in Exhibit 2. The distributor chose a different set of names for its application.

The salesperson would open the screen, see the recommended price, and then examine the customer’s status. Even though the system had already factored in the customer stratification, the sales force needed the additional comfort of knowing that core customers were properly identified. The strategy worked like this: If the salesperson was planning to ask for a 22% margin and the system came back with a 28% margin recommendation, maybe the salesperson would split the difference. In a pricing environment, a 1% increase in gross margin can easily mean a 20% increase in net margin.

The process worked better than expected with gross margins growing by more than 6 points (6% or going from 22% to 28% gross margin in our example). The key component was and is the customer stratification. The salesperson split the difference on the low side in the beginning but, as they gained confidence, moved closer and closer to the system’s recommendation.

Sales Force Redeployment

The sales force makes a sincere effort to call on the right customers and spend the right amount of time with those customers. Still, the salesperson may or may not understand whether the customer is in fact a Core customer or an opportunistic one worthy of pursuing. Without the right analysis, the sales force makes decisions about who to spend time with and give services to based on their perspective of the customer relationship. Sometimes they’re right, but often they give away services to Service Drain customers or discounts to Marginal customers thinking they are, in fact, Core or Opportunistic customers. Exhibit 3 describes the link between customer stratification and shareholder value.

A powerful example of working with Core customers comes from an oil field services firm. The sales representative worked with the operations manager for the customer on taking control of the warehouse. Up to that point, the distributor was the largest but not the only supplier for the operation. The operations manager had instituted a significant measurement system and was disappointed with the performance of the warehouse.

Contractors working for the customer ordered far more material than they needed since they did not trust the warehouse to have the material on time. The result was excessive, obsolete materials when the contractors did not use everything they ordered. The warehouse was awash in inventory.

The distributor’s sales rep worked up a strategy based on the customer’s measurements (which were driven by return-on-net-assets or RONA). He got the customer to agree to share improvement in RONA in exchange for the distributor managing the warehouse. The sales rep then worked closely with the contractors to build confidence, disperse the dead inventory through their own network, and improve picking and tracking procedures.

Since the distributor’s network was far larger than the customer’s, the distributor was able to reduce a significant amount of inventory through redeployment. By winning the contractor’s confidence, the distributor was able to significantly reduce excess orders. Finally, through demonstrating value add directly in RONA, the distributor won a larger portion of the customer’s business at that location and rolled the program out worldwide for an even greater gain.

The distributor did not take ownership of the inventory. The investment came in the form of the sales rep’s time to set up and run such a program and additional human resources in onsite management. The decision to redeploy these resources was made rationally based upon the customer’s status (Core). The additional services were directly compensated for through the RONA split. If additional resources are not compensated for, the distributor’s cost-to-serve rises without higher compensation and turns the customer into a Service Drain.

Only Scratching the Service

These examples only start to demonstrate the benefits of customer stratification. Future blogs will explore blending it with other best practices as well.

Best Practice: Inventory Stratification

2009-08-04T07:40:00.000-07:00

Best Practice: Inventory Stratification

By Dr. Barry Lawrence, Texas A&M University

The current economic environment is frustrating to say the least. Many have adjusted to lower volume and reduced their capacity (inventory, human resources, value added services, and even facilities) to reflect a lower business volume. Manufacturers have dramatically scaled back with some cutting capacity by as much as 80%. Demand has not decreased as much so most believe that soon (end of the year or sooner) production will be needed again (albeit at a lower level) and the economy should start grinding slowly forward. Issues with the banks, excess real estate inventories, and consumer debt will linger, however, and are expected to make the recovery a slow one.

Aggressive firms are already thinking about the recovery and seizing market share from weakened rivals. Those still gasping for air are trying to make it through the end of the year and praying for relief. Others want to sell out as soon as the markets recover. Still others are fighting off bankruptcy. In the midst of this chaos and with so many different priorities among distributors, how does one come up with a common set of strategies we can all discuss and share for the betterment of the distribution community?

The new NAW Institute for Distribution Excellence book Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line details best practices, their implementation, and ROI. These practices are valid in any economy but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we will introduce a best practice and how it can improve earnings and/or ROI under current economic conditions. We encourage readers to ask questions, debate results, and offer their own experiences with such practices so that we may further the knowledge of the community and the understanding of the science of distribution.

The book breaks business processes into seven groups (the 7S process group includes SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING and SUPPORT SERVICES) based on various distributor asset categories. This month, we focus on the STOCK group. The STOCK group has seven processes and we’ll discuss inventory stratification here.

STOCK: Inventory Stratification

Inventory stratification prioritizes investments in inventory based on customer service or shareholder value. Customer service often drives large, inefficient inventories in an attempt to be all things to all people. Shareholder value seeks to carry only profitable products, at reasonable levels (asset efficiency), producing maximum sales (cash flow), while also increasing market share (growth).

Inventory stratification techniques are well known but often not applied correctly. The practice levels for inventory stratification are as follows:

COMMON practice: 1) No inventory stratification (2) Product line grouping (3) Not connected to purchasing

GOOD practice: (1) Volume (sales $) based (2) Logistics (hits) driven

Revenue driven models, like sales in units or dollars, emphasize fast movers often at the expense of more profitable products. Customer service driven models, like hits, emphasize always having what the customer wants, when they want it, often at the expense of ROI.

BEST practice: (1) Profitability (GMROII) based (2) Multiple criteria based (3) Combination method

Profitability driven models, like Gross Margin Return on Inventory Investment (GMROII) or Turn and Earn, emphasize profitability often at the expense of economies of scale created by higher sales. The best approach will be some sort of combination model tied to the purchasing process.

A properly executed inventory stratification will ensure shareholder value and direct all purchasing decisions towards the firm’s financial strategy. An example purchasing scheme might be to carry “A” items with a solid safety stock, carry “B” items with a limited safety stock, “C” items with no safety stock, and eliminate “D” items.

Upon hearing such a strategy many will ask “How am I supposed to eliminate ‘D’ items when important customers require us to carry them?” The question demonstrates a fixation with sales as a stratification method. No matter how many times you explain that a ‘D’ item has no profits, almost never gets picked, and generates almost no sales, people will get concerned. The stratification needs to combine techniques and all parties must be educated on how it works.

So What’s the Impact?

Even with a combination technique, the average distributor has about 20 to 40% of their inventory in ‘A’ and ‘B’ items (great contribution to shareholder value) and 60 to 80% in ‘C’ and ‘D’ (negative contribution to shareholder value). Firms that execute inventory stratification connected to purchasing processes are able reduce or redeploy 20 to 50% of inventory in cases we have observed. The following exhibit describes the link between stratification and shareholder value.

When “cash is king” as it is now, inventory reduction takes center stage. One distributor faced a crisis last year when their sales were flat and inventories were expanding due to canceled customer orders with the onset of the recession (numbers have been simplified and somewhat disguised for confidentiality). Inventories ballooned from $8 million to $10 million in a few months. The expansion led to an increased financing need of nearly $2 million since supplier funds were maxed out.

A further problem was Accounts Receivable. As the economy worsened, customer Days Sales Outstanding increased from 30 to 40 days resulting in a need for another $1 million in credit just to stay afloat. So with no change in sales, the firm suddenly had to come up with an extra $3 million in credit.

Then the loan covenants kicked in. The distributor had been granted a line of credit up to 50% on good quality inventory. The economic slowdown and pressure on banks caused them to decrease it to 45% and disallow more inventory as potentially obsolete. The net effect was that even with a $2 million increase in inventory, there was effectively no increase in the line of credit.

The bank also gave 90% on Accounts Receivable (A/R) of less than 90 days. Due to reevaluating the distributor as more risky, they reduced the covenant to 80%. In addition, a greater percentage of customers went beyond 90 days as the economy trended downward. The net effect was almost no increase in credit to cover the increase in A/R. So the company found itself with nearly a $3 million shortfall, a potential death sentence for an otherwise profitable firm.

The firm was fortunate to have started an inventory stratification process before the storm hit. After analysis, they had $2 million in ‘A’ items, $2 million in ‘B’ items, $4 million in ‘C’, and $2 million in ‘D’. They set out to reduce ‘A’ and ‘B’ by $500,000 each(relatively easy to do), ‘C’ by $2 million (discounting would bring a 5% loss in value), and ‘D’ by $1 million (discounting 30%).

The firm freed up $3.6 million in cash to help get them through the crisis. They also “righted” the ship by improving their inventory quality and bringing it down to a manageable financing level. Loan covenants on inventory were restored to the previous 50% level by the bank.

What If Cash Flow Wasn’t the Problem?

The firm could have gone after the other shareholder objectives if they weren’t facing a cash crisis. Instead of only reducing inventory, they could have redeployed it to fast movers or into new products or markets spurring growth. The impact would have been higher profitability on increased sales with greater asset efficiency since the investment would be in ‘A’ and ‘B’ items.

About this Blog
“Managing in an Uncertain Economy” is a blog created by the Council for Research on Distributor Best Practices (CRDBP). The mission of the CRDBP, created by the NAW Institute for Distribution Excellence and the Supply Chain Systems Laboratory at Texas A&M University, is to create competitive advantage for wholesaler-distributors through development of research, tools, and education. CRDBP encourages readers of this blog to send in Comments and email this blog to other interested parties.

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